Download Learning Objectives 1 The Nature of Economic Growth

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Learning Objectives
1. Explain the costs and benefits of economic growth.
2. List the four fundamental determinants of growth in real
GDP.
3. List the main elements of Neoclassical growth theory.
4. Describe the new growth theories based on endogenous
technical change and increasing returns.
5. Explain why resource exhaustion provides society with
incentives for technological improvements.
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1 The Nature of Economic Growth
Because economic growth (increases in Y*) can go on over
very long periods of time, it is a much more powerful method
of raising living standards than the removal of recessionary
gaps.
Annual Growth Rate
Year
0
10
30
50
70
100
1%
100
111
135
165
201
272
2%
100
122
182
272
406
739
3%
100
135
246
448
817
2009
5%
100
165
448
1218
3312
14841
7%
100
201
817
3312
13429
109660
1
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Benefits of Economic Growth
Rising Average Living Standards
For all those who share in it, economic growth is a powerful
means of increasing living standards.
Alleviation of Poverty
Many of the poorest are not in the labour force, and hence are
unlikely to share in the higher wages that economic growth
brings. However, rapid economic growth does make it easier
to reduce poverty through income redistribution.
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Costs of Growth
Sacrifice of Current Consumption
Future growth is often encouraged by increasing current
investment and saving. For the economy as a whole,
however, this requires a sacrifice of current consumption —
this is an important opportunity cost of economic growth.
Social Costs of Growth
Economic growth usually involves the replacement of some
firms and workers with others. The process renders some
machines obsolete and also leaves some workers partly
obsolete. There are costs involved in making this transition.
2
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Sources of Economic Growth
The four fundamental sources of economic growth are:
1. Growth in the labour force.
2. Growth in human capital.
(Human capital is the term that economists use to
refer to the set of skills that workers have. Human
capital can be increased through formal education or
on-the-job training.)
3. Growth in physical capital.
4. Technological improvement.
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2 Established Theories of Economic Growth
Investment, Saving, and Growth
Investment is important because this is how the economy
accumulates physical capital. Increases in the stock of capital
will increase the future level of Y*.
We focus on the long run and ignore short-run fluctuations so
increases in future Y* also mean increases in future Y.
Empirically, societies with high rates of national saving have
high investment rates and, other things being equal, high
growth rates of real GDP.
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The Long-Run Connection Between Saving and
Investment
Recall that national saving is the sum of private saving and
public saving. Desired private saving is the difference
between disposable income and desired consumption. In the
long run, when real GDP equals Y*, we have:
Private Saving = Y* - T - C
Public saving is equal to the combined budget surpluses of
federal, provincial and municipal governments:
Public Saving = T - G
Therefore, National Saving = NS = Y* - T - C + (T - G)
= Y* - C - G
Real Interest Rate
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NS = Y*-C-G
Excess
Supply
•
i1
i*
i2
•
•
•
In the long run, the condition
that desired national saving
equals desired investment
determines the equilibrium
interest rate.
E
Excess
Demand
I*=NS*
•
I
Loanable Funds
Investment demand by
firms is negatively related
to the real interest rate.
The supply of national saving is positively related to the
real interest rate, since increases in the interest rate lead
to a decline in desired consumption.
At point E, the market for loanable funds clears and the
real interest rate is i*.
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Real Interest Rate
Suppose the supply of national saving increases, either
from a decline in household consumption or government
purchases. Thus, national saving rises at any interest rate
and so the NS curve shifts to the right.
i0*
In the long run, an increase
in the supply of national
savings reduces the real
interest rate and encourages
more investment by firms.
NS0
NS1
E0
•
i1*
• E1
I0* I1*
The higher rate of investment
leads to a higher growth rate
of potential output.
I
Loanable Funds
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Real Interest Rate
Now suppose that firms’ demand for investment increases.
This might be caused by technological improvements or by
government tax incentives encouraging investment. This will
shift the I curve to the right.
NS
i1*
i0*
In the long run, an increase
in the demand for investment
pushes up the interest rate
and encourages more saving
by households.
E0
•
• E1
I1
I0
I0* I1*
The higher rate of saving
(and investment) leads to a
higher growth rate of
potential output.
Loanable Funds
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Neoclassical Growth Theory
The Neoclassical growth theory is based on the the idea that
the four sources of economic growth can be represented with
an aggregate production function:
GDP = FT(L,K,H)
where L is the total amount of labour, K is the stock of
physical capital, H is the quality of labour’s human capital,
and T is the state of technology.
The notation FT reflects the assumption that changes in
technology will change the production function.
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When examining long-term economic growth, we interpret
output in the Neoclassical approach as potential output.
The key aspects of the Neoclassical aggregate production
function are:
1. It displays diminishing marginal product of both K
and L (when either factor is changed in isolation).
2. It displays constant returns to scale (when both K
and L are changed in equal proportions).
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L
Units of
Output
APL MPL
1
12.0
12.0
2
17.0
8.5
5.0
3
20.8
6.9
3.8
4
24.0
6.0
3.2
5
26.8
5.4
2.8
6
29.4
4.9
2.6
7
31.9
4.6
2.5
8
34.0
4.2
2.1
9
36.0
4.0
2.0
10
37.9
3.8
1.9
Units of Output
40
•
35
•
30
•
25
20
15
TP
•
•
10
2
4
6
8
10
Units of Labour
Holding K constant, increases in L
generate positive but diminishing
increments to output.
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According to the law of diminishing returns, marginal product
eventually falls as each successive unit of the variable factor
is added in combination with a fixed amount of another factor.
In the Neoclassical model, whenever diminishing returns
applies, increases in population lead to increases in GDP but
declines in per capita GDP — and thus falling average living
standards.
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Similarly, diminishing returns means that capital accumulation
on its own brings smaller and smaller increases in real per
capita GDP.
If K and L grow at the same rate, GDP will also increase. But
in the Neoclassical growth model with constant returns to
scale, this “balanced growth path” will not lead to
improvements in living standards. GDP will grow but per
capita GDP will be constant.
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In the Neoclassical growth model, technological change is
necessary in order to have sustained growth in living
standards.
Much technological change is embodied in new capital
equipment, so the process of investment is central to
encouraging technological improvements.
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Many — perhaps most — innovations are embodied in either
physical or human capital. These innovations cause continual
changes in the techniques of production and in the nature of
what is produced.
Measuring technical change is difficult. One popular — though
imperfect — method is Robert Solow’s “growth accounting.”
This method measures technical change as that part of growth
that cannot be explained by capital accumulation or labourforce growth.
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3 New Growth Theories
Endogenous Technological Change
In the Neoclassical model there is no explanation about how
innovation and the incorporation of new technologies are
determined. That is, technology is determined exogenously.
New growth theory incorporates the process of innovation and
incorporation of new technology into the aggregate production
function in a number of ways:
• learning-by-doing,
• knowledge transfer,
• market structure and innovation, and
• shocks and innovation.
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Increasing Marginal Returns to Investment
New growth theories emphasize the possibility that as
investment in some new area, product, or production
technology proceeds through time, each new increment of
investment is more productive than the last.
This contrasts with the Neoclassical assumption of
diminishing marginal returns.
The sources of increasing returns usually fall into one of two
categories:
• fixed costs, or
• knowledge.
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Fixed Costs
Successive increments of investment can yield increasing
marginal returns if:
• costs that are incurred by earlier investment expenditures
provide publicly available knowledge, and
• customer attitudes and abilities become more receptive to
new products.
Knowledge
Knowledge is an important factor of production and, because
much of it is a pure public good, it may not follow the law of
diminishing marginal returns.
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4 Are There Limits to Growth?
Resource Exhaustion
Current technology and resources could not support the entire
world’s population at the average Canadian standard of living.
But most economists agree that absolute limits to growth,
based on constant technology and fixed resources are not
relevant.
We must keep in mind that technology is constantly improving,
and this suggests that living standards can continually
improve.
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Pollution
Conscious management of pollution was unnecessary when
the world’s population was one billion people, but such
management has now become a pressing matter.
Conclusion
Growth can help the world address many problems. But
further growth must be sustainable growth, which should be
based on knowledge-driven technological change.
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